Interest Rate Averaging
Interest averaging impacts risk management practices of financial institutions
Interest rate averaging is a new optionality within mortgage products, which was recently introduced. This article offers an explanation of this development, and looks at the restrictions, methods used and the impact all this has on risk management and pricing.
Due to a declining trend of consumer rates in the Dutch mortgage market over the past years, interest rate averaging has gained an increased regulatory and media attention. This year, interest rate averaging is or will be introduced by multiple mortgage providers. As this is a new phenomenon, the impact on risk management and capital is widely unknown. Public perception is that interest rate averaging appears to be a goldmine for banks (FD, 2/2016). This article provides more insight into market practices on interest rate averaging as applied by Dutch Mortgage providers.
What is interest rate averaging?
Customers who borrowed money against a fixed rate a couple of years ago pay a much higher interest rate than the current mortgage rate, due to the decline in interest rates. Interest rate averaging can be seen as resettlement of an existing mortgage loan where the client immediately profits from the lower mortgage rate, while not having to pay an upfront penalty. Instead of paying the prepayment penalty, the penalty is spread out over the new fixed interest period of the newly settled mortgage. This can be advantageous for customers who want to decrease their monthly coupon payment. Aspects that influence whether interest rate averaging is beneficial for the client include the level of the rate, the type of mortgage, and the remaining fixed interest period of the mortgage. The market (i.e. clients, regulators, the government, competitors) forces financial institutions to take a position on offering interest rate averaging.
The calculation methods used by mortgage providers combined with the conditions applied result in a wide range of interest rate averaging approaches. Deloitte Financial Risk Management performed a benchmark study on the various methods applied. This study showed that there is no common method to calculate the interest rate after averaging, and that the impact on risk management measures varies among the approaches.
Impact of Interest rate averaging
Interest rate averaging has a significant impact on various aspects of risk management and pricing. It will impact among others:
- Internal Liquidity Adequacy Assessment Process (ILAAP): Interest rate averaging affects the behaviour of clients, which changes the prepayment rate used to define the liquidity risk of mortgages.
- Interest Rate Risk in the Banking Book (IRRBB): Similar to ILAAP, the interest rate risk measures will also change due to changes in prepayment speed.
- Market value: Interest rate averaging affects the market value due to a lower coupon and a longer fixed interest period.
- Solvency Capital Requirement (SCR) ratio: The change in market value leads to a change in both the own funds and in the risk reflected in the solvency capital requirement.
- Securitization: The introduction of additional optionalities, as interest rate averaging, may not be in line with the restriction underlying the securitization, which can cause a forced buy-back.
- Pricing: Interest rate averaging adds an additional optionality which ideally should be included in the pricing.
Financial Risk Management
Financial Risk Management (FRM) can support in selecting an approach, defining impact and incorporating interest rate averaging in pricing and risk management. Topics that this support can include:
- Analysis of different interest rate averaging approaches.
- Defining the areas of impact, based on the interest rate averaging approach and type of institution.
- Calculate the impact in the current situation and the impact under different interest rate environments.
- Determine how the models, methods and underlying assumptions shall be adjusted in order to incorporate interest rate averaging in pricing and risk measurement systems.
Would you like more information on the impact of interest rate averaging on risk management and pricing? Please contact Roald Waaijer at +31 (0)882884334 or Bauke Maarse at +31 (0)882884254.